Credit Rating Agencies- Can they be trusted?

A Credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings.
 
In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer’s credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.
 
Credit ratings are thus used by investors, issuers, investment banks, broker-dealers, and governments for broadly five following basic purposes:
credit
Additionally, it also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals, and universities.The credit rating industry is highly concentrated, with three companies – Moody’s, Standard & Poor’s and Fitch dominating the market landscape. According to rating agencies, ratings are opinions and not recommendations to purchase, sell, or hold any security. They further assert that they have the same status as financial journalists and are therefore protected by the constitutional guarantee of freedom of the press.

In the United States and Europe faulty credit ratings and flawed rating processes are widely perceived as being among the key contributors to the global financial crisis. That has brought them under intense scrutiny and led to proposals for radical reforms. The ongoing debate, while centred in major developed markets, will also influence policy choices in emerging economies: whether to focus on strengthening the reliability of ratings or on creating alternative mechanisms and institutions that can perform more effectively the role that in developed markets has traditionally been conferred on credit rating agencies.
 
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By incorporating credit ratings into their requirements, regulators effectively outsourced many regulatory functions to rating agencies and made credit ratings essential for issuers and the cornerstone of regulations across a range of financial sectors. As a result, rating agencies now play a critical role as de facto “capital market gatekeepers”- despite their apparent lack of liability and their reluctance to assume such a responsibility.
The value of such security ratings has been widely questioned after the 2007-09 financial crisis. In 2003 the U.S. Securities and Exchange Commission (SEC) submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest. More recently, ratings downgrades during the European sovereign debt crisis of 2010-11 have drawn criticism from the EU and individual countries.
 
The three major rating agencies have faced many credibility crises in recent years. Not long ago, Fitch was criticized for frequently downgrading the credit ratings of many countries and regions. It downgraded the sovereign credit ratings of several European countries, and the agency said it might even downgrade the credit rating of China within two years. Thus, it is not hard to understand that a single rating could lead to “big operations” by various countries.
 
In a capital market that relies heavily on the creditability, the credit rating can directly decide the capital power of an organization or country. As the financial market continues to develop rapidly, the investors are eager to learn about the true situations of the debtors so that they could optimize their investment options based on them to realize the investment safety and obtain more stable returns. In this sense, credit rating as a quantitative evaluation standard can not only provide investors with fair and objective information, but they can also be used by executives to check out and make decisions.
Investors will be exposed to greater risks when buying bonds issued by countries with low credit ratings. This means that lower credit ratings will likely cause debtors to face financing difficulties. Financing difficulties will worsen their financial conditions and in turn further lower their credit ratings. Under this circumstance, the credit rating agencies are under fierce criticism for the credit ratings they made. For instance, a credit rating agency said that it is “likely to lower China’s credit rating over the next two years,” about which each side has yet to reach a consensus. Is this credit rating agency seeking to make the funds flow back to European and American markets by sacrificing China’s national interests? Is China’s economic prospect as bad as it estimated? Can it provide some evidence concerning the credit rating? What this illustrates is a classic case of “crony capitalism”.
 
As the representatives of the credit rating system, the three major credit rating agencies should unarguably adhere to the principles of fairness and equality. Under the current circumstance, people have appeared to be unable to rely on the current opaque credit rating system to decide how to allocate their money. It is unclear whether the credit rating agencies are neutral third-party agencies or representatives of some interest groups.
 
People used to believe in the objectivity and impartiality of the three major rating agencies, but the unreliable ratings over recent years have shaken people’s confidence. It is hard to forget that when the global financial crisis occurred, these rating agencies, which were supposed to help diagnose and treat the economic trauma, unanimously chose to keep silent.
Financial markets need reliable quantitative credit risk assessments because reliable assessments can bring huge returns. These assessments directly determine the direction of cash flows and even the economic prospects of a country or a region.  
 
Credit rating agencies are far less influential and reliable than they were in the past. In order to regain people’s confidence, they need to provide sincere assessments and publish objective ratings lists, no matter the black or red lists.The ratings agencies would like you to believe that the source of their power is the accuracy of their opinions. But in fact, its true source is the extent to which their ratings have been embedded in various rules and regulations across the financial world. 
 
It all started back in 1975, when the Securities and Exchange Commission began to use such ratings to calculate how much capital broker-dealers should be required to hold. To prevent the proliferation of fly-by-night raters, the SEC designated a handful of firms as “nationally recognized statistical rating organizations,” or NRSROs. By the time the financial crisis hit, NRSRO ratings were embedded in thousands of regulations and private contracts, if not more, determining what securities money-market funds would be permitted to own, how much collateral counterparties would have to put up in trades, and countless other arcane matters.
 
Consider the issue of removing ratings from the process of determining how much capital banks must hold against various exposures. The banks say that there isn’t a ready alternative. Smaller banks argue that they don’t have the resources to use anything other than credit ratings, which are relatively cheap and easy, and that if forced to find alternatives they’ll have a harder time competing against large banks. The large banks argue that if they can’t use credit ratings, they’ll have a harder time competing against foreign banks, which still use ratings. Indeed replacing credit ratings could lead to competitive distortions across the global banking system and the domestic banking landscape.
 
That reference to the “global banking system” gets to another problem: Despite global dislike of the American rating agencies, ratings are ingrained in the global capital standards – even those implemented after the 2008 sub-prime crisis, which exposed the ratings agencies’ unreliability. The latest global regulatory framework (“Basel III”) continues to use ratings to judge creditworthiness.
 
This lingering attachment to the ratings agencies isn’t limited to banks and regulators. Investors, the very same people who got burned relying on the rating agencies three years ago don’t want to see them go. There are many market players who benefit from, and support, the status quo. In fact if investors no longer have ratings to rely on, then they’ll have to do the credit analysis themselves. If they’re wrong, they won’t be able to blame those accursed rating agencies!
 
In fact the allure of ratings goes beyond the avoidance of responsibility. Ratings actually help investors game the system. In what’s known on the Street as “ratings arbitrage,” funds that are statutorily prohibited from buying non-investment-grade bonds buy the highest yielding bonds with the lowest investment grade rating that they can find, thereby juicing their returns. That creates an artificial demand for securities that don’t merit the rating they received, at least by the market’s judgment. Ratings arbitrage is what put the most dangerous mortgage-backed securities in greatest demand at the peak of the subprime madness.
 
Thus what is primarily needed is a set of reforms that would facilitate better monitoring and governance of these very agencies. While there is no consensus on a single set of reforms, the measures that have been announced do show convergence around several objectives:
  • Managing conflicts of interest through governance reforms in rating agencies
  • Improving the quality of rating methodologies, particularly for structured finance
  • Increasing transparency and disclosure obligations
  • Introducing direct government oversight to replace self-regulation

Other regulatory measures are also being discussed, ranging from refining existing disclosure requirements to conferring a formal gatekeeper responsibility on rating agencies that would include a due diligence obligation and possibly some legal liability for their rating reports. But some commentators argue that such reforms are insufficient and merely treat the symptoms of the problems and not the root causes. These commentators tend to focus instead on three areas in which there has been much discussion but few reforms:

  • Promoting competition in the credit rating industry
  • Rethinking the issuer-pays business model and
  • Reducing the regulatory franchise of rating agencies.

However, it must be noted that “The rating system goes hand in hand with the development of large liquid, deep and international markets. It is a precondition and a tool for ensuring the smooth functioning of these markets.”  

Authorities have introduced a range of regulatory measures related to credit rating agencies in response to their failures in this crisis. The measures announced thus far are aimed primarily at introducing direct government oversight to replace self-regulation. By contrast, despite extensive debate, there has been limited action on promoting competition in the credit rating industry and revising the issuer-pays model – probably for good reason, because there are no easy solutions.
 
You may loathe them as everyone does, but reliance on the credit rating agencies turns out to be a terrible habit that almost no one is willing to break!

References

  • www.wikipedia.com
  • http://www.guardian.co.uk/business/2003/jan/28/usnews.internationalnews
  • http://www.slate.com/articles/business/moneybox/2011/08/moodys_junkies.html
  • http://www.slate.com
  • http://oversight.house.gov/story
  • Report of the High-Level Group on Financial Supervision in the EU

Citations

  • Turner Review: A Regulatory Response to the Global Banking Crisis
  • http://www.iosco.org

[The article is written by Mr. Varun Joshi. He is the Managing Partner of AV Realty Corp. and is a keen follower of Indian equity market.]

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Credit Rating Agencies- Can they be trusted?

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